Cover Story

Microsoft Defends Its Empire

When a Microsoft ( (MSFT)) salesman dropped by IT consultant Westcon Group's Tarrytown (N.Y.) headquarters for a round of negotiations in late 2008, Westcon's chief information officer, William Hurley, decided he had had enough. "I'm sick of this," he said to the sales rep, complaining of the high costs of buying and maintaining Microsoft's broad portfolio of business software. "I don't want to do this anymore."
Much to Hurley's surprise, the rep offered alternatives. Within weeks, Hurley agreed to receive a new version of Exchange—the back-office software that makes corporate e-mail systems run—for a monthly fee, with Microsoft maintaining the bulky program and data on its own servers. The deal promised to save the company hundreds of thousands of dollars a year in hardware, software, and IT personnel costs. "This is a very different Microsoft than it was two or three years ago," says Hurley.
That's for sure. The Internet has thrown even the mighty Microsoft back on its heels. No longer able to impose its will on the computing world, the Redmond (Wash.) software giant is scrambling to catch up with all the changes the Web is unleashing. Over the past few years, CEO Steve Ballmer has come to two conclusions about the future of his business. First, Microsoft needs to move away from selling software and toward renting it out, in order to compete with cheap or free Web alternatives. Second, it must revamp its programs to satisfy customers' desire for more Internet-based collaboration. Now, Microsoft is putting those ideas into action, overhauling not only what it makes but how to deliver and charge for it.
The front line of the new Microsoft is its highly profitable business division. The group includes the Office suite of applications (Word, Excel, PowerPoint, and the Outlook program, which lets users read and compose e-mails), as well as its SharePoint collaboration software and its Exchange e-mail server program. Microsoft in November began offering Exchange and SharePoint as a Web service for a monthly fee. For customers tired of maintaining these unwieldy programs on their own servers, the change is welcome: They usually end up paying less to subscribe to the software than they spent buying the program and paying for the staff and hardware to run it.
What's more, Microsoft has dramatically upgraded its Office applications. Microsoft Office 2010, scheduled to be released by the middle of next year, represents a radical departure from the past. For the first time, Microsoft will offer a free version of Office with limited functionality to customers who don't want to pay up for the whole shebang. Among other things, the free version, which will be supported in part by online advertising, will let users access any Word or Excel document remotely, via cell phone or a Web site.
The paid version is much heftier. It will allow teams of workers to create documents, spreadsheets, and presentations as a group in real time and track down other people with a click and invite them to join in. It also boasts a broader array of fonts and formatting options and much more number-crunching power than the free version. By focusing less on the PC and more on the people who use them across organizations, "We're trying to redefine our notion of productivity," says 14-year Microsoft vet Ayca Yuksel, who demonstrated the software for BusinessWeek in June.
As of now, Microsoft hasn't committed to offering Office 2010 as a monthly subscription service like it does for Exchange and SharePoint. Instead it'll charge its normal up-front price, and companies will maintain the programs on their own servers. But company insiders say sooner or later Office is likely to go the subscription route as well.
Microsoft is betting that the subscription model will generate fatter revenues—and, indeed, it should. Microsoft can charge big corporate customers significantly more to rent software and contract for service than it charges them just to buy the programs. The wild card is on the expense side: Microsoft doesn't know for sure how costly it will be to assume the maintenance load. The answer will determine whether the company can afford to make Office or other programs available via subscription anytime soon. Hanging in the balance is one of the great profit machines of all time.
Risky though the subscription gambit may be, Microsoft has few alternatives. The era of PC dominance is passing, as consumers and workers shift their computing to a dizzying array of devices, such as iPhones ( (AAPL)), BlackBerrys ( (RIMM)), netbooks, and Kindles ( (AMZN)). Intrepid customers can get software much like Office on the Web for free via Google Apps ( (GOOG)) and IBM's ( (IBM)) Symphony. As customers weigh the merits of those alternatives, Microsoft has had to slash the price of its Windows operating system and Office suite to compete. "The big danger for Microsoft is that its software will be commoditized," says Michael A. Cusumano, a professor at the Massachusetts Institute of Technology. "It's happening as we speak." Analysts expect that when Microsoft reports fiscal 2009 results in late July, annual revenue will have declined for the first time since the company went public in 1986.
To be sure, Microsoft remains one of the world's most profitable companies, with estimated earnings of $15.2 billion for the fiscal year ending June 30 on revenue of $59.9 billion. And it has generated plenty of buzz for its new Bing search engine, introduced in May, and its upcoming Windows 7 operating system.
But neither has lifted the company's languid stock, which, despite a jump since March, trades at the same price it fetched in 1998—even though the company has almost four times the profit. Analysts are no longer whispering that Microsoft's glory days may have passed—they're saying it openly. "The Roman Empire remained a pretty nice place to live for 400 years after Rome peaked," says longtime PC analyst Roger L. Kay. "But there's no doubt that the Microsoft empire is in decline."
Ballmer, naturally, disagrees. He exudes nothing but confidence in the upcoming Office rollout: "I think people are just going to say, 'Wow, they did it again.'"
A Messy Courtship A key player in the new Microsoft is Stephen Elop, an outsider from Silicon Valley brought in last year by Ballmer to overhaul the business division. Elop, a veteran of Adobe Systems ( (ADBE)) and Juniper Networks ( (JNPR)), has been pushing the makeover aggressively. A native Canadian, the 45-year-old father of five is known for his buzz cut and workaholic tendencies. He commuted to Silicon Valley from Toronto for six years and still pulls the occasional all-nighter.
While well-regarded for his operations and sales expertise, Elop was a controversial choice. Before arriving in Redmond, the biggest company he had run was Internet software maker Macromedia, whose $440 million in sales at the time was less than 3% of the size of Microsoft's business division.
Elop's messy courtship raised more doubts. In late 2007, Elop held the No.2 post at router maker Juniper, having joined the company less than a year earlier with a personal assurance from then-CEO Scott Kriens that he was next in line for the CEO job. As the year drew to a close, Ballmer flew to Toronto and spent hours at Elop's home discussing the Office job with him and singing Seattle's praises to Elop's wife, Nancy. With the press release announcing Elop as Juniper's new CEO already written, Elop told Kriens a few days after Christmas that he was going to Microsoft instead. Elop says the 10-minute phone call was "very tough" and that the move was "unquestionably the hardest decision I've ever had to make." (Kriens ended up recruiting Microsoft's Internet chief, Kevin Johnson, as CEO and says in an e-mail, "It all worked out for the best.")
Elop joined Microsoft in January 2008 with a mandate to overhaul the business group. Tops on the priority list: to use the Internet more aggressively as a way to deliver and improve Office's capabilities.
A "Looking-Glass Wall" Ballmer had started the process in 2004 after returning from a sales trip in which customers complained about the overhead and headaches associated with running Microsoft's software. He asked Ron Markezich, the vice-president responsible for Microsoft's own tech systems, to see if Markezich could figure out how to run Microsoft's Exchange e-mail software and SharePoint collaboration program for a few trial customers to use over the Net. Markezich found that Microsoft could do so—and save customers money.
Elop's job is to put that and other big ideas into action. Shortly after he arrived in Redmond, he began showing off a flashy video with futuristic visions of how Office could enhance people's productivity. One idea: a "looking-glass wall" that lets people on different continents communicate as though they were together—with real-time translation if they speak different languages and a display of the full history of e-mails and related documents. Elop also doubled the size of the staff at Office Labs, the team that made the video and is charged with dreaming up new ideas for the group.
This was a huge change for a division that had a reputation as Microsoft's no-nonsense boy scouts—never missing deadlines or releasing bug-filled code like their brethren in the Windows group. Rather than lavish global bashes featuring big-name rock stars, the team's idea of celebration after a product release is a 10-minute romp in a fountain outside Building 36 on the Redmond campus. Beer is available, but in moderation. "We're not the most colorful group," admits Jeff Teper, founder of SharePoint. "We'd rather let the results speak for themselves."
Elop is also changing the way the division prioritizes its investments. "We're going to make fewer, bigger bets," he says. One example: He more than doubled Microsoft's investment in SharePoint, which companies use to let employees share documents and collaborate on "wikis." Elop says he made the call after visiting customers around the world. "When something is hot, you pour gasoline on it," he says. The nine-year-old SharePoint business is one of Microsoft's fastest-growing, with sales climbing by double digits even in the weak economy.
Perhaps most important, Elop has championed the move to the "cloud," meaning customers can get Microsoft software from its giant data centers rather than from their own servers. He sped up the rollout of the Exchange and SharePoint subscription services and other online programs, which are now available in 19 countries. Hundreds of companies, from Westcon and GlaxoSmithKline ( (GSK)) to Coca-Cola Enterprises ( (CCE)), have signed up for what Microsoft calls the Business Productivity Online Standard Suite.
Ingo Elfering, vice-president for IT strategy at drugmaker GlaxoSmithKline, says his tech staff can now focus on more important projects than computer maintenance. "[Maintenance] has no more value to our business than paying the electric bill or serving food in the cafeteria," he says. "I really don't need to be buying groceries for my employees. I'm not very good at it."
But while Microsoft is tinkering with delivery mechanisms, what matters most is whether customers are willing to pay up for its wares in the era of cheap Web alternatives. Its hope is that Office 2010 will persuade customers to dig deep into their wallets. On July 13, Elop is expected to reveal the details of the program, which was designed very much with the Twitter generation in mind. One major change is something called "co-authoring." Rather than have one person create a document or PowerPoint presentation and then e-mail it around to others, teams will be able to work on the project simultaneously. One group member could grab a particular paragraph or slide and fiddle with it. Once they save the changes, others can see and weigh in on that bit of content.
Arriving Via the Web Another feature of Office 2010 is called "unified communications." When a user moves the cursor over the name of a colleague, up pops a box that shows whether that person is online—and offers the option of e-mailing, calling, or setting up a meeting. The program will also offer new social networking capabilities and ways to track down co-workers with specific skills.
Some corporate customers see big potential in blending Microsoft's software with the reach of the Internet. Elfering of GlaxoSmithKline says he wants Microsoft to make the paid version of Office 2010 available as a Web service now. He envisions a day when millions of companies share access to some of their knowledge. "If there were a collaboration platform out there with 60 million people, imagine the insights one could glean," says Elfering.
But first things first. Before Microsoft can roll out the Office subscription service, it needs to learn how to deliver Exchange and SharePoint profitably. It'll have to beef up its call centers, reduce the number of bugs in its programs, and in all ways bend over backward to keep customers happy. After all, if the software doesn't work, Microsoft won't get paid. At least not for long.
Such radical moves haven't come naturally. Given the company's enormous success over the years, Ballmer concedes it took him a while to get comfortable with Microsoft's new path. Now, though, he says he is convinced the shift will pay off down the road. "It's not that I'm in love with the past," Ballmer explains. "But we needed to think really hard before we embraced the future."

Warming Up to Microsoft

For years investors have fumed at Microsoft's mediocre products and profligate spending. Now comes a sudden warming trend. As BloggingStocks points out, the Bing search engine is winning good reviews, and the new Windows 7 software should spark a wave of PC upgrades next year. Throw in the most ardent belt-tightening in company history, and it's no wonder Microsoft shares have risen 55% since March.